Chile: Staff Report for the 2014 Article IV Consultation

KEY ISSUESPolitics: President Bachelet won the Presidential election on a platform to fosterinclusive growth and reduce inequality. Her government took office in March 2014 and is launching an ambitious policy agenda that includes important reforms in several areas, including taxation, education, productivity, and energy.Outlook and risks: Chile’s global environment is shifting, with a dimmer outlook for its main export, copper, and normalization of global monetary conditions. Growth has slowed markedly, resulting in a modest output gap. The peso has depreciated, feeding into inflation. Staff projects growth to bottom out in 2014 and then gradually recover. Key risks relate to a large and lasting drop in copper prices and global financial volatility.Policy mix: The freely floating peso is working as a shock absorber and will support the economic recovery. The policy mix with broadly neutral fiscal and accommodative monetary policy is appropriate. Room for further monetary easing has narrowed but space remains if domestic demand flounders, so long as inflation expectations remain well anchored. On fiscal, given the strong public finances, automatic stabilizers should be allowed to operate unimpeded and there is space for stimuli in the event of a major downturn. The commitment to close the structural fiscal deficit by 2018 is appropriate and should be phased in a way that avoids undue drag on the recovery. Should risks materialize, the freely floating currency is the first line of defense.Growth and equity reforms: Achieving strong growth while reducing inequality will require structural reforms. The authorities’ agenda focuses on the right areas but many details remain work in progress. Clarity on the details, timetables, and prioritization will reduce uncertainty and the risk of delays.Financial stability: Risks to financial stability appear contained, but it will be important to push through with regulatory reforms underway, including initiatives currently in Congress. Further effort will be needed to close regulatory gaps, in particular bankcapital requirements, relative to international benchmarks.

Abstract

KEY ISSUESPolitics: President Bachelet won the Presidential election on a platform to fosterinclusive growth and reduce inequality. Her government took office in March 2014 and is launching an ambitious policy agenda that includes important reforms in several areas, including taxation, education, productivity, and energy.Outlook and risks: Chile’s global environment is shifting, with a dimmer outlook for its main export, copper, and normalization of global monetary conditions. Growth has slowed markedly, resulting in a modest output gap. The peso has depreciated, feeding into inflation. Staff projects growth to bottom out in 2014 and then gradually recover. Key risks relate to a large and lasting drop in copper prices and global financial volatility.Policy mix: The freely floating peso is working as a shock absorber and will support the economic recovery. The policy mix with broadly neutral fiscal and accommodative monetary policy is appropriate. Room for further monetary easing has narrowed but space remains if domestic demand flounders, so long as inflation expectations remain well anchored. On fiscal, given the strong public finances, automatic stabilizers should be allowed to operate unimpeded and there is space for stimuli in the event of a major downturn. The commitment to close the structural fiscal deficit by 2018 is appropriate and should be phased in a way that avoids undue drag on the recovery. Should risks materialize, the freely floating currency is the first line of defense.Growth and equity reforms: Achieving strong growth while reducing inequality will require structural reforms. The authorities’ agenda focuses on the right areas but many details remain work in progress. Clarity on the details, timetables, and prioritization will reduce uncertainty and the risk of delays.Financial stability: Risks to financial stability appear contained, but it will be important to push through with regulatory reforms underway, including initiatives currently in Congress. Further effort will be needed to close regulatory gaps, in particular bankcapital requirements, relative to international benchmarks.

Context

1. Chile is confronting a changing external environment. As the world’s leading copper exporter and with a large, internationally integrated financial sector, Chile profited greatly from recent years’ global copper boom and easy international financial conditions (Figure 1). Chile achieved a substantial increase in per capita income, a fall in poverty, and an improvement, if more modest, in its skewed income distribution.1 Growth tailwinds are now reversing as the Fed has started to normalize policy (“tapering”) and the commodity boom is petering out. Although Chile is in a strong position to cope with these changes and associated turbulence thanks to its freely floating currency, credible monetary policy framework, robust public finances, and a track-record of macro-financial stability, the changing environment poses challenges for macroeconomic policy and, in particular, for the prospects for strong and more inclusive growth.

Figure 1.
Figure 1.

Chile: Past Growth Performance and Challenges Ahead

Chile’s changing external environment poses a policy challenge.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: World Economic Outlook (IMF), OECD, World Development Indicators (World Bank), UN Comtrade, and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Based on Sosa, Tsounta and Kim (2013).3/ Linear interpolation used to fill in missing data.

2. A new government has taken office. Former President Michelle Bachelet won the November 2013 elections and assumed office on March 11, 2014 for a four year term. Her coalition also won majority in both chambers in Congress. President Bachelet was elected on a platform to improve equity through major tax and education reforms. The platform also includes energy, labor, and productivity reforms, and a clear commitment to prudent fiscal policy. Annex I summarizes past Fund advice.

Current Conditions

3. So far, spillovers have been mixed: mild from tapering and severe from the dimmer global copper outlook. Though not immune, Chile has been remarkably resilient to the tapering-spillovers (Figure 2). The corporate sector has maintained access to external funding, capital inflows have remained buoyant, albeit with recent moderation, and the effect on EMBI spreads has been modest. Notably, Chile’s local currency long-term government bond yields have declined, reflecting policy credibility, monetary policy expectations, and low foreign participation.2 In contrast, the worsening global copper outlook has taken a toll on investment and growth and the effect seems bigger in Chile than in other copper exporters (Annex II). The peso has depreciated by 17 percent against the dollar since April 2013—amid monetary easing—and 11 percent in real effective terms.

Figure 2.
Figure 2.

Chile: Financial Market Developments

Financial markets have remained orderly but with some asset repricing.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Bloomberg, Central Bank of Chile, and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Morgan Stanley Composite Indices.3/ Unidad de Fomento (UF) is a unit of account adjusted for inflation.
A01ufig01

A Dimmer Outlook for Copper

(US cents per pound)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: World Economic Outlook (WEO) and Fund staff estimates.
A01ufig02

Financial Market Indicators During the Recent Turmoil

In line with its strong fundamentals, during recent episodes of financial volatility, Chile experienced a mild impact and a fast recovery.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Bloomberg and Fund staff estimates.1/ Negative means local currency depreciation.

4. Activity has slowed markedly (Figure 3). The growth moderation that started in 2012 became more pronounced in 2013 as private investment ground to a halt late in the year. The anticipated completion of large projects launched in previous years coincided with postponement of new projects. The first quarter of 2014 saw some recovery in activity and private investment, but durable goods consumption contracted on the back of a softer, if still quite tight, labor market. Net exports are providing an important offset. Although the slowdown has been sharp, much of it reflects an adjustment toward trend after a period of strong growth, and staff estimates a modest negative output gap.

Figure 3.
Figure 3.

Chile: Cyclical Position

Activity has moderated markedly, especially investment; while the tight labor market has also started to ease.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Haver Analytics, and Fund staff calculations.1/ Core inflation excludes fuels, fresh fruits and vegetables.

Recent GDP Developments

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Sources: Haver and Fund staff calculations.

5. The central bank has eased monetary policy. In October 2013, with inflation below target and a weakening economic outlook, the central bank bucked the tightening trend among emerging markets and cut the policy rate from 5 to 4 percent by April 2014 (Figure 4). The cuts transmitted quickly to interbank and lending rates, and added to peso depreciation. Nonetheless, credit growth has moderated for all types of credit, except for mortgages, which remain brisk.

Figure 4.
Figure 4.

Chile: Monetary Policy and Inflation

Amid contained inflation pressures and marked activity moderation, the Central Bank reduced the monetary policy rate

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Haver Analytics, and Fund staff calculations.

6. Inflation has picked up. The pass through from peso depreciation to consumer prices has been surprisingly swift. Inflation was 4.3 percent (y/y) in April, up from 1.7 percent in October 2013. More worrisome, although the largest spike was in tradable goods inflation, as would be expected, non-tradable and core inflation measures have also risen. Still, inflation expectations remain anchored at 3 percent over the two-year policy horizon.

A01ufig03

Despite a Rise in Inflation, Expectations Remained Anchored

(y/y, in percent)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile and Haver.

7. Fiscal policy has stayed broadly neutral (Figure 5). The structural deficit in 2013 was 0.8 percent of GDP (staff estimate), roughly unchanged from 2012 net of a one-off capital gains tax windfall (equal to 0.4 percent of GDP). The fiscal stance, measured by staff as the change in the non-mining primary structural balance, was broadly neutral. The fall in copper revenue shifted the headline balance to a deficit of 0.6 percent of GDP from a surplus of equal size in 2012, but central government net assets remained at 6.7 percent of GDP helped by valuation gains.

Figure 5.
Figure 5.

Chile: Fiscal Policy and Public Finances

Since 2012 the fiscal stance has remained broadly neutral and the public sector financial position is fairly strong.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Ministry of Finance, Central Bank of Chile, and Fund staff calculations.1/ For 2012, includes capital gains tax windfall (US$1bn or 0.4 percent of GDP) from a copper-related transaction.2/ For 2014, includes the expected yield of the 2014 tax reform as submitted to Congress.3/ Change in the non-mining structural primary deficit.

8. External imbalances have declined. Real depreciation and weaker domestic demand kept the current account deficit at 3.4 percent of GDP in 2013 (a year ago, staff had projected a widening to 4.7 percent of GDP) and shrunk it in the first quarter of 2014 to 3.1 percent of GDP (annual basis). Foreign direct investment has declined but remains the main source of financing, albeit with a growing debt component. According to the Fund’s EBA estimates, the peso is in line with fundamentals, and this view is supported by a broader set of indicators—brisk (copper and non-copper) export volume growth, adequate reserves, and strong international investment position (Figure 6). That said, external debt has increased and gross external financing needs, though smaller than in 2013, remain sizeable at 17 percent of GDP, roughly half of which is non-bank corporate debt.

Figure 6.
Figure 6.

Chile: External Stability

The current account deficit has narrowed and external stability risks remain contained.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Fund staff calculations Haver Analytics, Inc. and World Bank WITS.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Assessing Reserve Adequacy, IMF, February, 2011.

Peso Overvaluation

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Sources: Central Bank of Chile and Fund staff estimates.

Unadjusted current account deficit for the previous year.

9. Financial stability risks are contained. Bank capitalization appears adequate, profitability remains comfortable, and nonperforming loans are low and fully provisioned. Domestic deposits are the main funding source, and reliance on foreign financing (excluding capital) is low, at 8.5 percent of total liabilities. In the important life insurance sector, profitability appears healthy, with returns on equity above the OECD median. Chilean insurance companies conservatively tend to accumulate more capital than required by regulations and solvency requirements are being strengthened. In recent years, the sector has expanded into lower-liquidity, higher-risk investments (e.g., real estate). As for corporates in the context of easy global financial conditions, firms have increased their indebtedness to about 92 percent of GDP, surpassing pre-crisis levels, though most of the increase reflects FDI-related debt with likely less roll-over risk (Annex III).

Financial Soundness Indicators

(In percent)

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Sources: Financial Soundness Indicators (IMF) and Fund staff calculations.

Value for 2013 corresponds to November.

10. Real estate remains dynamic. Real mortgage credit expanded by 9 percent (y/y) in April, and house prices, following some deceleration, are rising again though with large regional variation (Figure 8). However, household indebtedness (mostly bank-financed) has remained broadly stable at about 55 percent of disposable income. Commercial real estate data are spottier, but an apparent oversupply of office space poses some risk to life insurers.

Figure 8.
Figure 8.

Chile: Real Estate Developments

There are no clear signs of significant misalignment with fundamentals.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Superintendence of Banks and Financial Institutions, Chilean Chamber of Construction, Global Property Guide, and Fund staff calculations.1/ Compiled by the Central Bank of Chile controlling for home characteristics.2/ Compiled by the Chilean Chamber of Construction, which only covers Greater Santiago, using the hedonic price methodology.3/ Includes purchase commitments.4/ Apartments located in the center of the most important city of each country; information compiled by the Global Property Guide.

Outlook and Risks

11. In staff’s baseline scenario, growth bottoms out in 2014 and then gradually recovers. In line with recent data prints, the driving forces behind this scenario are a continued gradual turn-around in private fixed investment, including in mining, and strong net exports, both underpinned by the monetary easing, real depreciation, and the recovering global economy (Box 1). Activity will gather strength in 2015, with growth reaching 4¼ percent (staff’s estimate of long-run potential) in 2016. But there is a clear risk that the recovery could be underpowered and bumpy, held back by sluggish private consumption, near-term policy uncertainty, and international shocks. Inflation will decline to 3 percent over the next 12-18 months as the temporary effects from the peso depreciation wears off.

A01ufig04

Activity Has Started to Strengthen at the Margin

(qoq s.a. growth; in percent)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile and Fund staff calculations.

12. Two risks dominate the outlook (Annex IV).

  • Copper prices. Copper represents over half of Chile’s exports, equaling 15 percent of GDP. A further sharp and sustained decline in copper prices—triggered, for example, by a drop in demand from China (which consumes about 40 percent of world copper)—would hurt investment, crimp growth, and require another round of substantial real depreciation. Previous staff analysis suggested that a 10 percent fall in copper prices reduces Chile’s GDP by 0.8 percent over eight quarters.

  • Global financial volatility. Financial spillovers to Chile from tapering and emerging market turmoil have been muted. And as shown in the Spring 2014 World Economic Outlook, Chile is less vulnerable to capital flow volatility than most other emerging markets thanks to its robust macroeconomic framework and deep local capital market (including large pension funds). Still, Chile’s large and internationally integrated financial system, the significant real-financial linkages, the increased corporate leverage, and the sizeable gross external financing need expose Chile to sudden stop risk.

External Conditions

(Average; percent change; unless otherwise indicated)

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Source: World Economic Outlook (WEO) database.

13. The authorities are in the process of reassessing their macroeconomic forecasts but broadly agreed with staff on the outlook and risks. On external risks, they saw a disorderly slowdown in China as most important, especially if associated with further postponement of copper-related investment projects. On financial spillover risks, they no longer see tapering as an immediate risk, as the earlier uncertainty has been resolved, but will remain vigilant of any major deviations from announced plans. Medium-term growth prospects and potential growth should improve with implementation of structural reforms.

Policy Implications

Given the structural character of the growth slowdown and the modest-sized output gap, structural reform rather than demand-side policies should have the primary role in strengthening prospects for strong and inclusive growth. Continued efforts to reinforce financial stability will also be important.

A. Policy mix

14. Monetary policy should remain vigilant to the inflation outlook. The present accommodative stance is consistent with keeping inflation in check over the policy horizon and supporting the baseline’s recovery. However, the recent broad-based spurt in inflation calls for caution and for interest rates to be left on hold absent a further weakening in domestic demand. Monetary policy normalization should proceed as the economy reverts toward potential.

15. A broadly neutral fiscal stance would be appropriate. It would be consistent with full execution of the 2014 budget (approved last year with a structural deficit of 1 percent of GDP) and would allow for a robust increase in expenditure, investment in particular, after under-execution in 2013. At the same time, the headline deficit will double to 1.2 percent of GDP and central government net assets will decline by about 1 percentage point. The government’s target of a balanced structural position by 2018 is welcome and should be feasible as activity recovers, though the consolidation should be calibrated to avoid an unduly contractionary stance. The strong public finances allow for automatic stabilizers to operate fully.

16. There is room to react if risks materialize. The floating exchange rate should be the first line of defense, in particular in case of a further sharp and lasting fall in copper prices and capital flow reversals. Foreign exchange intervention could help avoid excessive currency volatility, if needed. If domestic demand falters, further monetary easing could be appropriate though room has shrunk. Fiscal support—beyond automatic stabilizers—could be considered if there is a large decline in activity. In the event of a capital flow reversal, the authorities should also be prepared to contain liquidity pressures, including through expanding repo operations, broadening the range of accepted collateral, and setting up dollar swap auctions.

17. The authorities broadly agreed. The central bank stressed that monetary policy will continue to focus on inflation. The pick-up in inflation had been stronger than expected but the central bank was confident that this increase was temporary, as suggested also by market expectations, and that inflation would revert toward 3 percent during 2015. Still, the rapid rise in inflation was a concern. Fiscal policy will be cast around a target of a structural balanced position by 2018. The government is considering revisions to the 2014 budget that would likely include additional outlays relating to costs of the recent earthquake in the north and widespread fires in Valparaiso. They also noted that the macroeconomic assumptions on which the 2014 budget was based have turned out to be too optimistic and, therefore, a somewhat larger headline deficit could be expected this year. The government is committed to bring the structural budget to a balanced position by 2018 using receipts from tax reform.

B. Fostering strong and inclusive growth

18. Chile faces two important medium-term challenges: fostering strong and sustained growth and reducing inequality.

  • Growth. Rapid growth over the past decade was led by investment and employment expansion, while total factor productivity increased a paltry 0.4 percent a year (and was particularly lackluster in the copper sector). The shifting tailwinds raise doubts about the mining sector as a driver for future growth—even if some recovery is projected—and the scope for employment expansion is constrained by low unemployment and the decelerating working-age population (from 1.6 percent in 2013 to 1.1 percent by 2019). The floating exchange rate and the flexible labor market will be key in facilitating the needed economic adjustment. But fostering strong and sustained growth will also require structural reforms.

Contribution of Factors of Production to Output Growth

(Average annual percentage contribution)

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Sources: Central Bank of Chile, Ministry of Finance, and Fund staff estimates.

Alternative Scenarios for Medium-Term Growth

(Average annual percentange change)

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Sources: Central Bank of Chile, Ministry of Finance, and Fund staff estimates.
  • Equity. Inequality has declined but it remains high compared with the region and OECD countries. Chile’s inequality is reflected also in low intergenerational social mobility, which is largely caused by unequal access to quality education. Social public spending has risen significantly over the last two decades, especially on health and education, but still lags regional and OECD averages. The Chilean tax-transfer system is characterized by low progressivity and has been less effective in reducing poverty and income inequality compared with the experience in OECD.3

Socioeconomic Indicators Relative to Comparators

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Sources: World Bank World Development Indicators, PovcalNet Database, OECD, Socioeconomic Database of Latin America and the Caribbean (CEDLAS), Economic Commission for Latin America and the Caribbean (CEPAL) and Fund staff calculations.

Brazil, Colombia, Mexico, Peru, Uruguay

Simple averages

Values not shown if incomparable. See Chile’s Experience with Inclusive Growth, Selected Issues Paper, for alternative comparisons with the OECD.

19. The government is launching an ambitious policy agenda that could galvanize strong and inclusive growth, while preserving Chile’s record of prudent macroeconomic policy. The plans, most of which are under development, focus on the following areas:

  • Education and tax reforms. The government has proposed a major tax reform to reduce regressivity and raise 3 percent of GDP by 2018 in revenue to fund education reform, increase outlays on health, and raise public savings (see Box 2). The mission supported these objectives. The proposal prudently matches new spending with permanent revenue.

    • Education. Chile’s PISA score improved over the past decade and is the highest in the region but still well below OECD averages. In Chile, student performance is also highly dependent on the student’s socio-economic background. Thus, improving education will help on both growth and equity fronts. Chile’s public spending on education is low by international standards and has limited scope for efficiency gains, so improvements would require more resources.4 The government’s immediate reform priorities include expanding the coverage of daycare, increasing education subsidies for low and middle-income students, and overhauling the schools’ selection process to foster equal access to education (text table). The mission supported the general direction of the reform and underlined the importance of leveling the playing field and raising quality of early-childhood education.5

    • Tax reform (Box 2). The reform involves several changes to Chile’s integrated tax regime.6 The current system of tax deferral for undistributed earnings (in place since 1984) has become a source of significant tax planning and evasion—mainly benefitting those with higher incomes—and challenging to administer. The tax reform (expected to be approved in September 2014) is tilted toward taxing the upper-income brackets, including through its focus on capital income and closing loopholes, and should reduce the regressivity of the current tax system. Given the size and complexity of the reform there is some uncertainty over its expected revenue yield and economic impact. Further, there is not much international experience to draw on for the proposed new profit/dividend tax regime but higher taxation of corporate profits and capital income would likely dampen investment and, in particular, corporate savings, while instant depreciation and higher public savings would provide some offset. Strengthening the tax authority will help support the expected revenue yield; and the planned gradual implementation is welcome and would allow fine-tuning if needed.

  • Energy (Box 3). While demand for electricity has risen steadily (and will continue to rise), investment in the sector, including in generation, has stalled. Energy reform is a top concern for the business sector and a priority for the government. The mission commended the government’s plan to promote energy investment and efficiency, and to facilitate entry and the use of new, clean technologies.

  • Infrastructure. Chile ranks well in international comparisons but with scope for improvement. The mission welcomed the government’s focus on transportation and logistical hubs (including, importantly, ports) and water and telecommunication infrastructure. Frontloading infrastructure investment could also boost investment and growth in the near term.

  • Labor market. The government is considering a number of labor market reforms. The mission encouraged in particular reforms to promote female labor force participation (e.g., training and improved access to daycare), which, despite important progress over the last decade lags OECD and regional averages and is particularly low for lower-income groups. As for the minimum wage, which is quite binding in Chile, the government’s commitment implies an increase by about 20 percent over three years at the time of a weaker labor market. The mission stressed the importance of maintaining a labor market that allows for sufficient flexibility while fostering equity.

  • Business climate. In World Economic Forum and World Bank Doing Business rankings, Chile scores high in the region in most categories, and compares well with OECD peers. The “business-in-a-day” reform approved in 2013 pushed Chile up in business environment rankings. And the Bankruptcy Law approved in early 2014 addressed one area where Chile lagged the most. The authorities’ plans to promote research and development, job training, small and medium-enterprise management, and competition should help spur innovation, growth, and economic diversification.

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In education, Chile ranks the highest within the region, but well below OECD countries.

(PISA Learning Outcomes; percentile ranks; higher is better)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Source: OECD PISA (2012) and Fund staff calculations.Sample includes 69 countries.

Elements of the Education Reform Agenda

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Source: National authorities
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Infrastructure quality is high in Chile by regional standards, but lags behind the OECD countries.

(Percentile ranks; higher is better)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Source: World Economic Forum Global Competitiveness Report (2013-2014) and Fund staff calculations. Sample includes 148 countries.

Selected Indicators of Competitiveness

(percentile rank; higher means better score)

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Sources: World Economic Forum (WEF), Global Competitiveness Rankings 2013-2014, World Bank Doing Business 2014 and Fund staff calculations.

Mean. LA6 includes Brazil, Chile, Colombia, Mexico, Peru and Uruguay

20. The authorities emphasized that the reform agenda is designed to provide a strong boost to medium-term growth and achieve a fairer distribution of income, which is important for social stability. The tax reform will bring needed fresh fiscal resources that will be used prudently on education and health and on increasing public savings. Improving access to high quality education will strengthen long-term growth prospects but also attack a root cause of inequality. And the planned agendas for energy reform and productivity, innovation and growth will address the main concerns of Chilean industry. All in all, the authorities were convinced that the implementation of their bold reform program should have an important positive impact on medium-term growth prospects and potential output.

C. Reinforcing financial stability

21. Chile’s financial system is large, with significant links to the local economy, the region, and the rest of the world. Financial system assets exceed 200 percent of GDP. Chilean banks (and corporations) are net borrowers in world markets. Subsidiaries of foreign banks account for a large share of bank assets. Foreign participation is also significant in the insurance and pension fund sectors. Moreover, in recent years, domestic banks have expanded their operations outside of Chile. Further, bank credit equals 77 percent of GDP, so bank linkages to the real economy are large. Thus, the system is exposed to regional and international developments and has extensive linkages to the real economy. So far, the tapering effects have been mild and financial system risks remain contained.7

Financial System Structure (2012)

(assets as a share of system total and GDP; in percent)

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Source: Superintendence of Banks and Financial Institutions, Superintendence of Insurance and Securities, Superintendence of Pensions, and Fund staff calculations.

Assets under management.

Includes mutual funds, investment funds, investment funds for foreign capital.

22. Chile has made considerable progress in enhancing oversight, but further efforts would strengthen the resilience of the system. Much of the progress has built on the 2011 FSAP (Annex V). But important parts of the agenda remain unfinished. The mission encouraged the new authorities to push forward with reforms to buttress the resilience of the bank and nonbank system.

Financial Sector Reforms in Progress

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Source: National authorities.

23. Banking sector soundness is being reinforced. While bank soundness indicators do not point to immediate risks, real estate, funding, and corporate leverage developments merit watching.

  • Real estate exposure. Mortgage loans represent about one-quarter of banks’ loan portfolio and the share of mortgages with elevated (80 percent or higher) loan-to-value (LTV) ratios has stabilized at a relatively high 60 percent. Prompt implementation of regulation underway linking mortgage credit provisioning to LTV levels would be important, and further action (hard limits on LTVs and debt-to-income ratios) might need to be considered. The mission also encouraged the authorities to address real estate data gaps, in particular for commercial real estate.

  • Bank funding. The banking system’s loan-to-deposits ratio—an often-used measure of liquidity risk—is high by international comparisons.8 The main reason is its heavier reliance on institutional deposits and, on the asset side, its higher share of loans. The Basel III Net Stable Funding Ratio (NSFR) is a broader measure and the 2011 FSAP Update found Chilean banks well-positioned to meet the NSFR. The mission welcomed the work of the Superintendence of Banks and Financial Institutions (SBIF) and the Central Bank to enhance liquidity regulation and reporting, taking into consideration recent proposals of the Basel Committee on Banking Supervision.

  • Corporate exposure. In recent years, corporate debt has risen (as a share of GDP), and profits and liquidity ratios have worsened from pre-crisis levels, especially in the construction and retail trade sectors that also have a large share in bank commercial debt. Corporate loans represent roughly half of banks’ portfolios, so banks’ exposure is significant. That said, local and global appetite for Chilean corporate debt remains strong, firms’ currency mismatches appear limited, and other indicators of corporate debt vulnerabilities do not point to acute risks (see Annex III). Central bank stress-tests find the banking sector solvent even under extreme scenarios.9

A01ufig08

Non-Bank Financial Institutions

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Superintendence of Banks and Financial Institutions, Superintendence of Insurance and Securities, Superintendence of Pensions, OECD and the Chile’s Mutual Funds Association. 1/ Returns are showed for Pension Funds type C, out of pension funds type A to E (ranked from more to less risk appetite).

24. The soundness of the non-bank system is also being strengthened further.

  • Insurance companies.10 The important life insurance sector (with assets equal to 20 percent of GDP) is expected to expand as the number of retirees increase. Longevity risk is being mitigated by regular review of mortality tables to reflect future life expectancy improvements, as recommended in the 2004 FSAP. As for credit risk, a longer average maturity for assets than for liabilities exposes life insurers to a decrease in interest rates. Life insurers’ growing direct exposure to commercial real estate merits watching, though stress tests undertaken by the Securities and Insurance Supervisor (SVS) find no significant concerns. Exposures to domestic corporate bonds (almost one-third of life insurers’ investments) also merit continued monitoring. The mission encouraged speedy approval of the law now in Congress that would introduce a risk-based supervisory system, including changes in solvency requirements.

  • Fund management industry. Chile’s fund industry is led by the rapidly expanding mutual fund sector, which is large relative to other emerging markets. Its assets (14 percent of GDP) are primarily in fixed income securities, and about half in money market funds (fixed income with maturity of 90 days or less). The 2013 law Ley Unica de Fondos which became effective on May 1, 2014, puts the industry under a unified legal framework, modernizes the regulatory framework, and improves investor protection by enhancing the supervisory powers of the SVS and setting qualification requirements for fund managers.

  • Pension funds. Chile’s privately-administered pension system is large by international standards. The government has appointed a commission to propose parametric changes to ensure adequate replacement rates in the face of declining investment returns and rising life expectancy. The government also plans to create a publicly-managed pension fund to complement the six privately-managed funds. In response to concern from the mission on how this might affect the industry, the authorities stressed that the new fund manager would operate under the same legal and regulatory framework as the others and that it would focus on enrolling workers not currently picked up by private funds (e.g. self-employed, rural).

25. Multiple agencies provide close and active financial oversight but the framework and governance could be strengthened. The financial industry is regulated by the Central Bank, and supervised by SBIF, SVS, and the Superintendence of Pensions. The Financial Stability Council, chaired by the Minister of Finance, facilitates coordination and data sharing. Two laws currently in Congress, which will provide a legal framework to the Financial Stability Council and strengthen the operational independence of SVS, should be implemented promptly once approved. But it will also be important to strengthen the independence of the banking supervisor (SBIF).

26. Conglomerates pose a challenge for supervision and a consolidated approach would be more effective. Most financial institutions in Chile are part of conglomerates, which tend to be large, complex, and prone to regulatory arbitrage and intra-group contagion. Chile’s financial oversight structure relies on a silo approach, based on sectoral supervision and built-in firewalls (such as related-party exposure limits). The authorities have strengthened oversight of conglomerates within the current legal framework, including by advancing risk identification based on case studies, tightening related-party exposure limits for banks, and improving the coordination and information exchange mechanisms among supervisors. When approved, the Financial Stability Council law will remove data sharing constraints among supervisory bodies that have hampered effective supervision. While these advances are important, a more comprehensive approach (as suggested by the 2011 FSAP) would be more effective. This would require a clear allocation of powers and responsibilities for continuous consolidated supervision, prudential regulation at conglomerate level, and corrective actions to address compliance with the framework.

27. Implementation of other initiatives would strengthen financial resilience further. The mission encouraged prompt congressional approval of legislation expanding the credit registry with comprehensive credit history from banks and nonbanks. Furthermore, the revision of the General Banking Law mentioned in last year’s staff report remains unfinished, and the mission recommended that the authorities give it a new push, focusing on incorporating Basel III capital standards, improving the legal framework for bank resolution, and strengthening the SBIF’s independence.

28. The authorities explained that they are committed to push ahead with financial sector reforms. They are committed to ensuring prompt approval of the legislative initiatives already in Congress. They are also committed to pushing forward with other financial sector reforms, including revising the General Banking Law to complete the adoption of Basel bank capital standards, strengthen SBIF’s independence, and modernize the banking resolution, though the timing of these reforms would require careful consideration given the broader policy agenda. In the shorter run, the Central Bank has already put in consultation the new proposed regulation for the sound management of banks’ liquidity risk.

D. Enhancing the fiscal framework

29. There is scope to refine Chile’s fiscal framework. Chile has a well-earned track record of prudent fiscal policy, formalized, since 2001, in a fiscal rule that has become a model for other countries. The rule was strengthened with the creation in 2013 (by ministerial decree) of a Fiscal Council to oversee its implementation. Though there is no urgent need for changes to the framework, the mission suggested consideration of some modifications.

  • The rule/target. The rule is simple and understood by the public and markets, and has shielded the budget from the business cycle and changes in copper prices, while allowing for a flexible response when warranted. The structural target is set by each administration for its four-year term and can be changed mid-stream. To provide more predictability and a stronger anchor for fiscal policy, especially after deviations, clearer guidance on medium-term objectives (e.g., structural balance or net assets) could be embedded in the rule itself. When the rule was created the authorities set a structural surplus target of 1 percent of GDP. While circumstances are now different (e.g., the government net asset position) and this target may not be appropriate, a small structural surplus for “steady state” would help preserve the government net asset position. Further, an explicit escape clause to allow discretionary policy in the event of large, clearly defined shocks would enhance clarity while preserving flexibility.

  • The Council. A law now in Congress will give the Council a stronger legal basis and will hopefully be approved soon. The authorities could also consider strengthening the Council’s autonomy and broadening its mandate (e.g., to include assessing outturns against targets).

30. The authorities appreciated the recommendations but did not see, given the already heavy agenda, revisions to the fiscal framework or the Council’s mandate as immediate priorities. They also noted that the appropriate medium-run fiscal target is a topic that will need further consideration and public discussion.

Staff Appraisal

31. Chile is confronting a challenging macroeconomic environment. Activity has slowed markedly, mostly reflecting an adjustment toward trend after a period of rapid growth. There are signs of a budding recovery but it is subject to considerable uncertainty and risk. And looking ahead, Chile’s growth prospects are affected by waning, even reversing, tailwinds to growth as global monetary policy begins to normalize and the copper price boom peters out. Chile also faces the headwind of a slowing working-age population.

32. Strengthening the prospects for strong and inclusive growth will require structural reforms. Chile is ahead of the curve in terms of building strong and credible policy institutions, flexible markets, and achieving macroeconomic stability. There is no single bottleneck to growth that stands out. Rather a comprehensive reform effort will be needed to rekindle productivity, spur investment, and boost human capital.

33. The government’s reform focuses on the right areas. The tax reform stands to achieve a welcome reduction in regressivity, close loopholes, and raise permanent revenue to fund education reform and additional health spending, and raise public savings. While the tax reform would likely dampen investment and, in particular, corporate savings, other key elements of the reform agenda could boost medium and long-run growth prospects. In particular, a well-designed education reform that focuses on improving access and quality at all levels of schooling, especially at younger ages, would be a win-win for growth and equity. Likewise with reforms that boost female labor force participation. Labor market reforms should make sure the market remains flexible to support a dynamic economy and the needed adjustments, while fostering equity. Reforms to upgrade key infrastructure and spur innovation would help boost productivity growth and investment. Greater clarity on details, timetables, and priorities—followed by rigorous implementation—will be critical to reduce uncertainty and risk of delays.

34. The current macroeconomic policy mix is broadly appropriate. The freely floating exchange rate is acting as a shock absorber, facilitating adjustment, and supporting the recovery. Monetary policy can remain accommodative so long as inflation expectations remain anchored. Fiscal policy should remain broadly neutral and with full operation of automatic stabilizers. The authorities’ commitment to achieve a balanced structural fiscal position by 2018 is appropriate—and the path should calibrated to avoid excessive drag that could scupper the recovery—and the resulting increase in public savings is welcome.

35. Enhancing the fiscal framework would help preserve fiscal space. Providing clearer guidance on medium-term fiscal objectives in the framework itself would provide a stronger anchor for fiscal policy, especially after deviations. A small structural surplus target over the cycle would help preserve strong fiscal buffers. An escape clause for discretionary policy in the event of shocks could enhance clarity further while preserving flexibility. The authorities’ plan to put the Fiscal Council on a more solid legal basis is an important step, but strengthened autonomy and a broader mandate would improve its effectiveness.

36. Chile should build on the progress achieved in recent years in enhancing financial oversight. Chile has made significant progress, building on the 2011 FSAP, but important parts of the agenda remain unfinished. It will be important to complete the initiatives now in Congress relating to risk-based insurance supervision, a comprehensive credit registry, stronger governance and independence of the Securities and Insurance Supervisor, and a new legal framework to the Financial Stability Council. It will also be important to follow up with reforms to align capital standards with Basel III, and provide greater independence to the Supervisor of Banks and Financial Institutions. As the economy is adjusting, corporate sector financial health and leverage, as well as the developments in the still dynamic real-estate sector should be monitored closely. Finally, given their dominant role in the financial system, the ongoing strengthening of supervision of financial conglomerates is important and welcome. Building on the progress achieved, consideration should be given to a more consolidated approach to oversight of conglomerates.

37. Staff proposes to hold the next Article IV consultation on the standard 12-month cycle.

Spillover Transmission Channels and Effects

Chile is a highly open economy. Its trade and financial openness indicators are the highest in the region. Chile is also highly dependent on commodities exports (see Figure 9).

Figure 9.
Figure 9.

Chile: Spillovers and Exposures

Chile remains exposed to global conditions both through financial and real channels.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Superintendence of Banks and Financial Institutions, World Economic Outlook, and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ VGB=British Virgin Islands, CYM=Cayman Islands and BMU=Bermuda.

Openness Scores

(In percent of GDP)

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Source: Spring 2014 World Economic Outlook.

Average includes Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela

Interest rates and commodity prices are key transmission channels for shocks. Recent IMF work in the Western Hemisphere Department Regional Economic Outlook and World Economic Outlook highlight Chile’s sensitivity to various types of shocks and are summarized in the table below.

Potential Spillover Effects

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Source: Spring 2014 Regional Economic Outlook Western Hemisphere and World Economic Outlook.

Effect in 8 quarters for all shocks except the commodity price index.

Average includes Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela, except for the impact of commodity prices, which averages Bolivia, Brazil, Chile, Colombia, Ecuador, Peru, and Uruguay.

Average effect in 2014-19 relative to 2012-13 average growth rate.

Under the baseline, there is a robust medium-term impact from the U.S. growth pick-up and a more moderate impact from the increase in interest rates. For example, the recovery in U.S. growth in the second half of 2013 will have a negligible effect on Chile’s growth in 2014, but a more substantial effect by end-2015 (all else equal). The increases in the effective U.S. federal funds rate, the 10-year U.S. Treasury bond yield, and Chile’s EMBI yield in the second half of 2013 impart a modest moderation on Chile’s growth by end 2014 and 2015.

Tax Reform 1/

The authorities’ tax reform proposal has three main objectives: (i) to raise 3 percent of GDP in revenue to finance an increase in spending on education (1.5 percent of GDP) and other social program (0.5 percent), and close the structural fiscal deficit (1 percent); (ii) to make the tax system more progressive; and (iii) to streamline savings and investment incentives and reduce tax avoidance and evasion. The reform will be implemented over four years.

Key elements are:

  • Reform the taxation of dividends. A key part of the reform is to include undistributed profits in the shareholders’ personal income tax base. While the current tax system—under which the progressive personal income tax on profits is deferred until distribution (as dividends)—was designed to foster savings and investment, it has also created some challenges. The monitoring and enforcement of the system requires substantial resources from the tax authority to track retained profits (in a ledger called FUT), some dating back decades. Further, the system has become prone to tax planning and evasion (activities that primarily benefit the well-off).

  • Raise the flat corporate income tax rate from 20 to 25 percent and lower the top marginal personal income tax from 40 to 35 percent.

  • Introduce measures to foster investment for small and medium-size enterprises. Measures include instant depreciation of investment (large companies would be eligible for 12 months); establishing a unique simplified tax regime with greater coverage; and increased tax credit for fixed-asset purchases.

  • Modify real-estate related taxes and strengthen some excise and green taxes. VAT will be charged on the sale of new houses; the existing VAT credit to builders of small houses will be reduced; and capital gains from house sales will be taxed (except from seller-occupied houses). The financial transaction (stamp) tax will also be increased. As for green taxes, the reform includes an import tax on highly-polluting diesel vehicles and an emission-based tax for industrial activity.

  • Strengthen the administrative capacity of the revenue authority by revamping international tax norms and auditing practices, improving access to information, and strengthening equipment and staffing.

Tax Reform Key Measures

(in percent of GDP)

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Source: Ministry of Finance (Dipres)

Steady state level.

Includes reduction of max. personal rate (-0.10% of GDP)

1/ See Chile’s Tax System and Reform, by D. Rodriguez-Delgado, Selected Issues Paper.

Electricity Sector in Chile

Chile imports about three-quarters of its energy needs, including for electricity generation. The Central (SIC) and Northern (SING) Interconnected Systems represent 75 and 24 percent of installed generation capacity. SIC is mostly hydropower and serves the central part of the country with over 90 percent of the population. SING is mostly thermal power, based on coal, natural gas and oil, and it serves the northern parts where the mining industry is located. Though demand for electricity has been rising steadily, several generation projects have been delayed due to environmental and administrative reasons.

A01ufig09

Installed Capacity by Source

(In Megawatts)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Source: Ministry of Energy.
A01ufig10

Chilean Electricity Prices Compared to Median OECD

(In $/MWh)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Source: OECD/IEA.

Average prices in Chile are not very different from the rest of the world. There can be large prices differences across sectors and regions in Chile, but the averages are broadly in line (in levels or trend) with regional and OECD averages.

A01ufig11

Electricity Prices by Sector, 2011, Cross Country Comparison

(In $/MWh)

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: OECD and Latin American Energy Organisation (OLADE).

The government’s energy agenda, launched in May 2014, seeks to promote investment and competition, while building consensus with local communities. The focus is on facilitating new entrants, clean technologies, and energy efficiency, and improving the interconnection of the SIC and SING grids.

Energy Reform Agenda: Targets by Numbers

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Source: National authorities.
Figure 7.
Figure 7.

Chile: Macro-Financial Stability

Risks to financial stability appear contained but some aspects warrant continued vigilance.

Citation: IMF Staff Country Reports 2014, 218; 10.5089/9781498380331.002.A001

Sources: Central Bank of Chile, Superintendence of Banks and Financial Institutions, World Development Indicators (World Bank), Financial Stability Indicators (IMF), and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Other LA6 includes Brazil, Colombia, Mexico, and Peru.3/ Other LA6 includes Brazil and Mexico.4/ Other OECD includes Canada, France, Germany, Italy, Japan, United Kingdom and United States.
Table 1.

Chile: Selected Social and Economic Indicators

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Sources: Central Bank of Chile, Ministry of Finance, Haver Analytics, and Fund staff calculations and projections.

Contribution to growth.

The methodology to compute the unemployment rate changed in 2009.

Headline balance adjusted for the economic and copper price cycles.

In percent of non-mining GDP.

Table 2.

Chile: Summary Operations of the Central Government

(In percent of GDP; unless otherwise indicated)

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Sources: Ministry of Finance and Fund staff calculations.

Based on the authorities’ medium-term fiscal projections in the 2014 Budget Law, adjusted for staff’s GDP and copper price projections and includes Tax Reform Bill as sent to Congress on April 2014.

Based on staff’s output gap estimates and WEO copper prices.

In percent of non-mining GDP.

Table 3.

Chile: Summary Operations of the Public Sector 1/

(In percent of GDP)

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Sources: Ministry of Finance and Fund staff calculations.

This table reflects the authorities’ revisions to historical official data to bring the fiscal accounts in line with GFSM 2001.

On a cash basis. Municipalities hold neither sizable financial assets nor debt.

Includes the effects of valuation changes (exchange rate).

The data reported here does not include depreciation as an expense.